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If all the recent talk from Federal Reserve members about plans to taper off the central bank's program of purchasing Treasurys and mortgage-backed debt was designed to test the temper of the bond market, the results have been nothing short of scary.

In the past few weeks. the Fed has discovered that when the bond market starts to worry about the end of the Fed's stimulus program and begins to unwind its long positions, there are few buyers for bonds or mortgage-backed securities. And when there are few buyers and everybody wants to sell, bonds drop like a stone.

We've all been worried that when the Fed starts to unwind its stimulus of the financial markets, it could set off a market rout.

We -- and the Fed -- have discovered that we were right to worry.

And now the question is: What can the Fed do to stem a drop in bond prices that is definitely too far and too fast?

That's an important question for bondholders, obviously, but also for investors in stocks. Some volatility in bonds will move some investors into stocks. But too much volatility in bonds is simply scary and sends money rushing out of all financial assets.

Bonds have had a terrible six weeks.

Treasurys -- remember that they're used as a benchmark for risk-free return -- have lost 10.7% from April 30 through the close on June 7, as measured by the Bloomberg U.S. Treasury Bond index.

image: Jim Jubak

Jim Jubak

Other debt instruments, such as mortgage-backed securities, have had an even worse period. The iShares FTSE NAREIT Mortgage Plus (REM) exchange-traded fund, which tracks real estate investment trusts that buy mortgage-backed securities, declined 12.8% from April 30 through June 7. Annally Capital Management (NLY), a REIT that manages a portfolio of mortgage-backed securities, was down 15.4% from April 30 through June 7.

Even the mighty have taken their lumps. Mr. Bond, Pimco's Bill Gross, has seen one of the funds he manages, Pimco Corporate and Income Opportunity (PTY) fall 13.5% from April 30 to June 7.

Extreme, unjustified, hysterical

The drops seem extreme, unjustified, overdone, hysterical. After all, while the worry is that the Fed will start to taper off its $85 billion in monthly purchases of Treasurys and mortgage-backed securities as early as its June or July meetings, in reality, the Fed hasn't done a dollar of tapering yet, and a September or October schedule for any move seems more likely. And even then, the Fed isn't likely to move especially rapidly.

The yield on the 10-year Treasury has gone up only to 2.17% from 1.84% a month ago and 1.64% a year ago.

But the drops don't seem extreme, unjustified, overdone or hysterical at all when you consider the certainty that the Fed will move to withdraw stimulus from the financial markets sometime in late 2013 or early 2014 -- unless the U.S. economy tanks. That will send interest rates higher. And bond prices lower.

Given that certainty, it's hard to figure out why anyone would buy bonds or other fixed income securities at all. Yields are unattractively low and prices are headed lower in the long term. So why buy?

The drops we're seeing in the market for Treasurys, corporate bonds and mortgage-backed securities are, from this perspective, exactly what you'd expect when a market begins to unwind huge long positions and finds that there aren't many buyers.

Think a

bout it this way: An increase in the yield on the 10-year Treasury to 2.5% from today's 2.17% -- certainly not inconceivable when the yield on the 10-year Treasury has gone to 2.17% from 1.84% in a month -- would produce a drop in the price of a $1,000 Treasury to $868. That's an additional 13.2% loss, on top of the 10.7% loss that the Bloomberg Treasury index shows over the last six weeks.

3 things that could turn this around

What could turn this situation around?

For the risk of loss of capital of that magnitude, a Treasury buyer is currently getting paid 2.17%. That seems like an insane bet.

It's a wonder that there are any buyers.

In the short term I can think of three things -- and they would probably wind up working in concert.

First, the yen could stop rallying against the dollar. When the yen was falling, money flowed into dollar-denominated assets, including Treasurys, because the dollar provided a safe haven from the decline in the yen. The extreme liquidity of the Treasury market -- it's so big that it's easy to move in and out of even if you manage huge positions -- added to the attractiveness of the market as a safe haven.

On June 7, the dollar stopped its fall against the yen, and today the greenback rebounded, climbing 1.6% against the yen. After the dollar's fall against the yen, the currency has enough headroom against the yen -- a

move from Friday's close at 97.56 yen to the dollar to the top of the pre-rally range near 103 -- to make buying Treasurys an attractive bet on a rising dollar.

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 Good for stocks

Second, the drop in Treasurys, mortgage-backed securities and other debt instruments has been so fast (an 11% decline in Treasury prices in six weeks is huge for the bond market) that betting on a bounce is now attractive.

You don't have to believe in Treasurys as a good buy over the next six months to believe in buying Treasurys over the next few weeks. Especially if you're willing, as I would be, to bet that in surveying the carnage, the Federal Reserve is likely to start talking up the bond market both in public speeches and in conversations with market makers in Treasurys.

I think you're likely to hear a spate of commentary as a result of those Fed comments saying a decision to taper off asset purchases is off the table for the Fed's June and July meetings. (The Fed doesn't meet in August.) That talk will work to orchestrate a bond-market bounce. The bounce is likely to be even bigger in the market for mortgage-backed securities, since the Fed is even more motivated to support this market. Much of the Fed's efforts in the most-recent round of quantitative easing have been directed at the mortgage market, and I think the Fed will do all it can to preserve the hard-won gains in the housing market.

And third, the bond market, once its near-term panic subsides for the reasons cited above, is likely to realize that fundamentals for bonds aren't terrible.

The weak first-quarter U.S. gross domestic product numbers now look likely to be followed by weak second-quarter growth. But that weak growth doesn't look so weak that it will lead to a big surge in defaults in the corporate high-yield-bond market (aka junk bonds) from current historically low levels.

There's not even a whiff of inflation in the United States. The Fed's preferred inflation indicator, the Personal Consumption Expenditure deflator, rose at a tiny 0.7% annual rate in April. That low rate of inflation means that even at 2.2% or so, the real yield on 10-year Treasurys (that is the yield after subtracting inflation) is the highest in two years.

All of this argues for a bounce, followed by some stabilization in the bond market over the next few weeks and maybe even into the fall (when we can start worrying about a possible tapering off in the Fed's purchases of Treasurys and mortgage-backed securities starting in October).

A lack of panic in the bond market would be good for stocks as well.

But a bounce and stabilization won't change the longer-term picture. What we've learned about the bond market in the last six weeks isn't especially reassuring. Once the market becomes convinced that the Fed is on the verge of tapering off its purchases, the rush for the door is massive and disorderly. Buyers become few and far between, and losses, especially measured against the usual volatility of the bond market, are scarily large.

Any short-term rally in bonds shouldn't lull you into complacency about the risks to your bond portfolio.

We've had a dry run at what this market will look like in the event of selling on a belief in Fed tapering. It has been really ugly. Even if bondholders get a respite from the damage, they should use it to reduce the risk from bonds in their portfolios.

Updates to Jubak's picks

These recent blog posts contain updates to the stocks in Jubak's market-beating portfolios:

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When in 2010. Jim Jubak started the mutual fund he manages, Jubak Global Equity Fund (JUBAX +0.32%, news), he liquidated all his individual stock holdings and put the money into the fund. The fund did own shares of Apple as of the end of March. Find a full list of the stocks in the fund as of the end of March here.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

Click here to find Jubak's most recent articles, blog posts and stock picks.

 

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